Regulation Proposals Could Lead to JP Morgan Mae and Citi Mac

The White House regulation proposal will inadvertently turn private companies into government sponsored enterprises

If there is anything crystal clear about the evolution of the financial crisis, it’s that Fannie Mae and Freddie Mac were problems. These government sponsored enterprises (GSEs) significantly contributed to the housing bubble by taking excessive subprime risk, knowing they had a taxpayer funded safety net backing their $1 trillion exposure. Exacerbating the excessive risk taking behavior was the Congressional protection Fannie and Freddie enjoyed-particularly from Rep. Barney Frank and Sen. Chris Dodd, who stopped GSE reform in 2003.

Logic would suggest that Washington should avoid creating more Fannies and Freddies. But President Obama’s proposed financial sector regulatory overhaul will ironically wind up turning the largest private financial companies into GSE-like entities, with an institutionalized bailout system.

The central plank of the White House regulatory proposal is a “council” of top regulators tasked with detecting systemic risks and using the power of the Federal Reserve (Fed) to prevent another crash. Such a council, made up of the Fed, SEC, FDIC, and others, would have significant sway on financial markets, even without authority to take any action. If the council announced that there was a particular systemic risk, Wall Street would react swiftly, likely with massive selloffs of a company in the council crosshairs. This kind of soft power would give the council immense behind the scenes influence.

In addition to this council, the proposal suggests categories for firms based on their size and interconnectedness with the rest of the financial sector. Financial institutions deemed too big and interconnected to fail, “Tier 1 firms” as the proposal calls them, would be given the highest capital reserve requirements and be subject to increased oversight. The augmented cash on hand requirements might do some firms good, but the increased reserves will only do so much in the event of another crisis. Several of the bailed out financial institutions wouldn’t have survived even with higher ratios because they simply had too much toxic debt and became insolvent (most notably AIG).

Furthermore, the President’s proposal suggests the development of a special “resolution” authority that would have the power to seize and take apart non-bank financial institutions-including investment banks and insurance groups like AIG-if those firms posed a systemic risk. Working closely with the systemic risk council, this resolution authority would act like the FDIC does for banks. Bankruptcy laws have been well developed over the past several decades, and they play a helpful role in winding down insolvent banks. It would not be inappropriate in theory to establish a legal structure for large, non-bank bankruptcies. But the resolution authority faces the practical problems of how the insurance fund will be financed and what it means in context of the other proposals.

When these three aspects of regulatory overhaul come together-a council, Tier 1 designation, and bankruptcy insurance fund-the result is actually a formalized too big to fail structure that encourages financial institutions to take on more risk knowing they have taxpayer protection.

Tier 1 regulatory status tacitly means a financial institution that is deemed too interconnected with the financial system to fail. By bracketing off a certain segment of the market, regulators can hold bigger institutions to higher standards, but in doing so they create an elite class that will take advantage of its new status. Coupled with a safety net, the Tier 1 investment banks and financial product specialists will know that any major losses would be absorbed by the-likely taxpayer funded-resolution authority. This means the special class of firms could operate with an implicit bailout guarantee.

Some may argue that this is inevitable, that we can’t let interconnected companies fail, and that this is a necessary part of regulation. But the whole notion of special privileges created by regulation strikes at the core of what regulation is supposed to do. The goal of regulation is to provide a framework for fair competition. Firms cannot compete on even ground if the regulatory framework gives some institutions an advantage over others.

The White House proposal singles out a class of the financial sector and provides it with taxpayer sponsorship. With taxes funding at least part, if not all, of the insurance for big financial firms facing a collapse, the government will have leverage to make demands on the Tier 1 firms, much like what happened with Congressional mandates to Fannie and Freddie. Sure, the regulatory plan doesn’t call for the nationalization of these banks, but with this new oversight authority in Washington, political interference in operations on some level is bound to raise its ugly head.

The Treasury’s forced sale of Merrill Lynch to Bank of America is a prime example of how Uncle Sam might ask for a favor or two in exchange for this new government sponsorship. Bank of America wanted to back out of its proposed purchase once the weight of subprime mortgages became more difficult to bear, but former Treasury Secretary Henry Paulson thought it would be bad for the market to have the Merrill sale fall through. Given the vice grip bailouts gave to Paulson, Bank of America had little choice but to go through with the sale when asked to-and to be quiet about the extortion as it happened.

Furthermore, giving the government the power to declare that a firm is a systematic risk opens up a wide door for financial institutions to lobby and trade favors to ensure that their firm will be left alone by the regulators-or in academic terms, regulatory capture.

Similar scenarios are virtually guaranteed with Washington essentially turning the top tier of financial institutions into GSEs. Especially considering that, even after all the problems of Congressional demands on Fannie and Freddie were revealed last September, Rep. Frank has gone back to the GSEs to demand they lower lending standards for condo buyers. While lower standards are political gold and may move more people into housing, they were a central part of the growth of the housing bubble, a prime mover towards issuing more subprime loans. The politics of Washington simply don’t mix with the proper business decisions that need to be made on a day-to-day basis.

As Congress weighs the regulatory proposals from the White House and others, careful attention must be paid to the unintended consequences of otherwise noble ideas. A good first step would be to ensure that any systemic risk oversight authority has no teeth or soft power. A second way to avoid the problem of regulation creating new GSEs all over the financial sector would be to make the resolution authority’s process painful enough, with enough disincentives for company executives that the safety net is avoided at all costs and only exists for the extreme scenario.

The days of gentle Fannie- and Freddie-like bailouts must be over. Ultimately, members of Congress must keep in mind that regulation, first and foremost, is supposed to provide a framework to foster competition. Companies and their operators must not be allowed to take risks with taxpayer money, and there must be some skin in the game for everyone.